Supply and command

Easy money in natural-resources stocks is over, fund manager says

SAN FRANCISCO (MarketWatch) -- Natural-resources mutual-funds have outperformed every other fund category over not just three or five years, but 10 and 15 years as well. To make good money, all a resourceful fund manager needed was a stake in commodities, energy, coal, industrial metals and other assets that are hard to get and in demand.

But this low-hanging fruit is now mostly picked over, said Mackenzie Davis, co-manager of RS Global Natural Resources Fund
RSNRX, +1.24%
While commodity prices are likely to rise for years, a new chapter for investors is beginning, he claims -- one that will force shareholders to be savvier about the resources stocks in their portfolios.

"For the last five years you just needed to own commodities, and if you were anything from 1% to 100% you were pretty happy," Davis said. "Now you really need to know what you own, both in terms of the fundamentals of the commodity and the business and being conscious about risk."

In what Davis calls "phase two" of the commodity boom, supply constraints and strong demand will keep prices high. But it also will cost producers more to drill, dig, mine, scrape and generate.

Accordingly, he said, investors must pay closer attention not just to a commodity's price, but also to expected returns on a company's exploration and production ventures.

"Every time there's a new, large project announced, we try to understand the economics," Davis said. "Where on the industry cost-curve does that project sit? If you're going to own a stock and not a commodity, you need to know the underlying economics of the assets."

Investors in RS Global Natural Resources know exactly where they sit. The fund typically is more diversified than most of its peers, which has kept longer-term returns average but provided below-average risk. Class "A" shares rose 25.1% in the 12 months through April 9, lagging its category's 31.8% average gain, according to fund-tracker Lipper Inc. The fund's three-year annualized 25.6% return also trails the group's 27.1% average return.

FirstEnergy Corp.

Looking forward, Davis said the most attractive resource companies are those involved with North American natural gas, aluminum, oil and electricity.

He and his colleagues are especially focused on low-cost, unregulated power, which led to an investment in FirstEnergy Corp.
FE, +1.60%

The company's markets in Ohio and Pennsylvania are deregulating, and meanwhile efficiently run coal-fired and nuclear-powered plants give it a competitive advantage, Davis points out. He predicts improving margins and returns for FirstEnergy over the next five years.

"Power is probably the commodity that is the most mispriced relative to its long-term value," Davis said.

On Thursday, shares of FirstEnergy Corp. added 81 cents to $73.65.

XTO Energy Inc.

For a stake in natural-gas production, Davis favors XTO Energy Inc.
XTO, +0.30%
which operates solely in the U.S. and is a good example, he said, of a company that spends shareholders' money wisely.

Return on invested capital is a critical signpost for a resource-stock investor, Davis said, adding that XTO Energy knows how to keep its costs low. The company also is expanding its footprint in natural-gas rich areas including East Texas and the Barnett Shale in North Texas, Woodford Shale in Oklahoma and Fayetteville Shale in Arkansas.

"We look for two things in stocks," Davis said. "We look for either improving returns on capital or sustainable high returns on invested capital. That almost by definition is a good company."

Shares of XTO Energy lost a nickel on Thursday to $63.55.

Century Aluminum Co.

"We're pretty excited about the fundamental outlook for aluminum," Davis said. That's an unconventional view given rising costs for this industrial metal and uncertain demand from big users such as China.

But low-cost aluminum producers with a tight grip on expenses can make money even in adverse climates, Davis noted, and that view led the fund to take a position in Century Aluminum Co.
CENX, +2.94%

The company is a small operator of aluminum smelters in the U.S., and those operations generate decent if predictable returns, Davis said. But what really interests Davis is the way Century Aluminum is reinvesting profits: chiefly to a project in Iceland with the potential to reduce overall costs and increase returns, he said.

"This is a company going through a pretty material structural change," Davis said. "They're going from having a bunch of average assets to reinvesting in very low-cost assets and seeing a dramatic shift in the company's return profile."

In trading Thursday, shares of Century Aluminum closed at $70.29, down 67 cents.

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